How to deal with drawdown periods

drawdown

Every good strategy has its drawdown periods. Drawdown is the difference between the equity highest high and equity lower low and has two components: depth and length, both very hard to bear by human traders. Why drawdown periods are normal? Because market is not deterministic (it doesn’t move according to strict rules that can be defined), if it have been like that we wouldn’t have had drawdown periods at all. If you see a system that doesn’t show drawdown periods than you have to be sure that system is somehow curve fitted. You fund a live account and start trading with great expectations. You win a few times and the world is yours. You already see yourself quitting your boring daily job and hiring a boat somewhere just like those fishy sales pages promise. If then did it (after all they posted many images with fancy cars and beautiful islands, they can’t lie like that, right?), then you can do it too. And suddenly, one day, BANG! Everything seems to be going down!  What’s the common psychology behind these events? Please read the following steps, do they sound familiar? 🙂

1. I buy a system, win a few trades, everything is working as it should, I’m happy and dream about quitting my daily job and retire.

2. All my gains are wiped out, the equity goes down, panic time! The system is not good at all, let’s drop it and stay aside for a while until it makes profit.

3. In the meantime, it’s time to move on, there are plenty profitable systems out there, what was on my mind when I chose this crappy system? But I will recover everything!

4. The new system is now installed on my live account and delivers steady and consistent profits every day, every month, everything is great and forex is the best thing ever happened to mankind since Armstrong stepped on the Moon!

5. Oh what do I see here? I’ve just wake up and..all my profits are gone!! I got a margin call! Nothing left on my account..Perhaps the first system was not so bad after all, better lose a few pips then have my account blown into pieces! I see it made some profits in the meantime, I’d better put it on my live account again. Wait..I don’t have a live account anymore, I have to fund another one.

6. First system is now installed but it keeps losing. Why? I saw it made good profits and recovered all previous losses..while I was busy with the system that lost all my money..ok, time to trash it for good! There must be another profitable systems out there..

7. Return to step 1 and begin again!

8. You finally realize after so many losses that forex is nothing but a big scam and quit.

That’s why 95% of so called traders (read EA kiddies) lose their money. Forex is not a scam, but it takes balls of steel and lack of emotions to succeed where others fail every day. Ok, it’s hard, but how to deal with prolonged drawdown periods?

  • First of all, you must perform a very deep analysis of your system before even consider of trading it live. You need to know the maximum historical drawdown depth, the maximum historical length, maximum stop loss, maximum take profit, average stop loss, average take profit, number of consecutive wins/losses. You should expect at least the maximum historical drawdown! It will come sooner or later, it’s not a matter of WHEN, it’s a matter of IF. Monte Carlo analysis is good at providing those figures. If the equity goes down more than Monte Carlo Worst Case Scenario then the system is invalidated by the market and has to be stopped. It may have produced good results in the past, but past performance is not a guarantee for future performance.
  • Adjust your risk according to the maximum drawdown you are willing to bear. For example I’m ready to bear a 15% drawdown and stop the system when/if it reaches 25% drawdown. That much I’m willing to suffer but others can take more than that, so please feel free to set your maximum acceptable draawdown and adjust the risk accordingly.
  • Don’t reduce or increase the risk! Just let the system do its job. If you reduce the risk you miss the recovery, if you increase the risk you may suffer even more drawdown! The wisest thing is not to interfere once. If your system really obeys all long term profitability rules, history tend to repeat itself and it will hopefully recover.
  • Accept your losses. They are part of the trading. Without them we all would have been billionaires by now. Be willing to accept that you can lose, even the best systems fail sometimes. Do not trade what you can’t afford to lose!
  • If you are still in profit but your account is in drawdown don’t feel sorry for your lost profits and don’t let your emotions take over you. Take a look at my picture:
forex robot

Forex robot

The equity rose to 30%, everything was great, then it suddenly dropped to 16%! Hard times, eh? Then it recovered until 27% but right as I’m writing this, it points down again! According to my analysis this was to be expected, nothing unusual here, in fact my analysis predicted much worse periods for this robot! Well, get used to it, that’s how forex works! Clear your minds and tell yourself day by day that there is no other way to make profits in forex then conquer your emotions!

Get ready to spend countless days and nights by analyzing a system, test it on demo first for at least 2 months but once you can really tell is good and appropriate for you, then stick to it until the end and maybe you have a chance to survive and get rewarded for your patience, dedication and discipline!

Thanks for reading! If you find this useful, please share, don’t keep it just for yourself 🙂